Does a Stronger System of Law and Order Constrain the Effects of Foreign Direct Investment on Government Size?

Abstract

The flow of foreign direct investment (FDI) has increased the challenges governments face in carrying out their fiscal responsibilities. A country’s system of law and order enables or constrains the implementation of government policies, and consequently influences whether the size of government responds to changes in FDI inflows and outflows. We test this hypothesis by fitting a semiparametric model of government consumption to a panel of developed and developing countries with within-country variation. Over a short data frequency, the average compensating response of governments in developing countries to an increase in FDI inflows is larger by a factor of five than that of developed countries. These significant level effects of FDI inflows are driven by law and order and are adjusted for differences in per capita income across countries. The larger the compensating response of a government, the bigger is the constraining effect of a stronger system of law and order. The efficiency hypothesis seems empirically valid for developing countries with a moderate system of law and order. Over a long data frequency, we find a strong (negative) link between FDI inflows and government consumption, and increases in law and order weaken this link. For both data frequencies, FDI outflows have no level effect on government consumption, whereas the empirical regularity of strong and robust inertia in government consumption exists in all countries.